The Disastrous Consequences of Weak Financial Sector Policies

What is the role of the financial sector in development? Does it really contribute, or does it merely respond to the demands of the real sector? Are markets simply casinos for betting, or do they perform some productive role? Shouldn’t the development community just focus its attention on more important issues, such as health, education, and the real sector?

I hear these questions all the time. It is not surprising because prominent economists also hold conflicting views. Many development economists do not even bother to discuss the role of the financial sector in development. Joan Robinson famously stated “Where enterprise leads, finance follows,” and Robert Lucas has argued that the role of finance in the literature on growth has been “over-stressed.”

But at the other extreme, Joseph Schumpeter observed “The banker…authorizes people in the name of society…to innovate” and Merton Miller stated: “That financial markets contribute to economic growth is a proposition almost too obvious for serious discussion.” This debate is crucial since it affects the decisions of policymakers to prioritize financial sector reforms, and the attention they pay to identifying and adopting appropriate financial sector policies. Where do we come out?

Financial Development is Pro-Growth

While theory provides complex and conflicting predictions on the impact of financial development on long-run economic growth, a growing body of empirical research produces a remarkably consistent story. Financial markets and institutions arise to mitigate the effects of information and transaction costs that prevent direct pooling and investment of society’s savings. In doing so, they perform important functions: financial systems help mobilize and pool savings, provide payments services that facilitate the exchange of goods and services, produce and process information about investors and investment projects to enable efficient allocation of funds, monitor investments and exert corporate governance after these funds are allocated, and help diversify, transform and manage risk.

Empirically, the services provided by the financial system exert an important impact on long-term economic growth. First, countries with better-developed financial systems tend to grow faster. And a large body of evidence suggests that this effect is causal: hence financial development is not simply an outcome of economic growth; it contributes to this growth. Second, we now also know more about the “how” of the impact of finance on growth – it promotes firm entry by easing the ability of financially constrained firms to access external capital, innovate, and expand; and by allowing firms to manage their risks better and to choose more efficient organizational forms such as incorporation.

Financial Development is Pro-Poor

Finance can also shape the gap between the rich and the poor and the degree to which that gap persists across generations. Financial development may affect to what extent a person’s economic opportunities are determined by individual skill and initiative, or whether parental wealth, social status, and political connections largely shape economic horizons. The financial system influences who can start a business and who cannot, who can pay for education and who cannot, who can attempt to realize his or her economic aspirations and who cannot. Furthermore, by affecting the allocation of capital, finance can alter both the rate of economic growth and the demand for labor, with potentially profound implications for poverty and income distribution.

Theoretically, again, how financial development affects inequality is not clear. However, an emerging bulk of empirical research points toward the conclusion that improvements in financial contracts, markets, and intermediaries expand economic opportunities, reduce persistent inequality, and tighten the distribution of income. For example, access to credit markets increases parental investment in the education of their children and reduces the substitution of children out of schooling and into labor markets when adverse shocks reduce family income. Better functioning financial systems stimulate new firm formation and help small, promising firms expand as a wider array of firms gain access to the financial system.

Besides the direct benefits of enhanced access to financial services, research also indicates that finance reduces inequality particularly through indirect, labor market mechanisms. Specifically, accumulating evidence shows that financial development accelerates economic growth, intensifies competition, and boosts the demand for labor, disproportionately benefitting those at the lower end of the income distribution. Hence, finance is not only pro-growth, but it is also pro-poor.

How to Avert Disaster?

As the 2007 financial crisis spread around the world, the potentially disastrous consequences of weak financial sector policies have moved to the forefront of policy debate once again. At its best, finance works quietly in the background, contributing to growth and poverty reduction; but when things go wrong, financial sector failures are painfully visible. Both success and failure have their origins largely in the policy environment; hence getting the important policy decisions right has always been and continues to be one of the central development challenges.

What can governments do to develop their financial systems? Quite a bit. For their financial systems to thrive, governments need to ensure a stable political system, fiscal discipline and sound macroeconomic policies. Institutional development – such as protection of property rights, effective enforcement of contracts and information infrastructures – are critical elements in financial system development. Regulation and supervision of financial systems and ensuring a contestable system are crucial for stability and efficiency. Governments also have an important role in building inclusive financial systems by expanding access.

This is a complex and challenging agenda that requires much work. Combining research analysis with practitioner experience can help temper and tailor reform to individual country circumstances. Given all the evidence, policymakers should prioritize financial sector policies and devote attention to policy determinants of financial development as a mechanism for promoting economic development.

Demirguc-Kunt, Asli. 2010. "Finance and Economic Development: The Role of Government." In The Oxford Handbook of Banking, ed. Allen Berger, Phillip Molyneux, John Wilson. Oxford, UK: Oxford University Press. 729-55. (PDF version available here)

Comments

Asli, while I do not doubt the importance of the financial system for economic development, your confidence in the statistic evidence that it contributes to economic growth does not seem warranted to me. Maybe I am missing something.
I replicated the panel regressions in one of the key papers in this literature and showed that when conservatively done, they fail a specification test. I.e., reverse causality has not been ruled out. See A Note on the Theme of Too Many Instruments, published in the Oxford Bulletin of Economics and Statistics. In fact growth regressions are in general disrepute, which is one reason the Spence Commission, for which the paper you cite was written, concluded "We do not know the sufficient conditions for growth. We can characterize the successful economies of the postwar period, but we cannot name with certainty the factors that sealed their success, or the factors they could have succeeded without. It would be preferable if it were otherwise.

David, I was referring not only to growth regressions which do suffer from serious identifications problems as we all know. But there is quite a bit of other evidence that suggest finance matters for growth and that reverse causality alone is not driving this relationship. The literature addresses the identification problem better by using industry and firm level data, and in-depth analysis of individual country cases and the impact of specific financial sector reforms, which all tell a remarkably consistent story. Individual papers are cited and discussed in the background paper for the Growth Commission. Please have a look for a detailed literature review.

Most of what you say is rather motherhood and apple pie ---- governments need to ensure a stable political system, fiscal discipline and sound macroeconomic policies, protection of property rights, effective enforcement of contracts and information infrastructures ...... etc.
Industrialized economies have had these attributes for a long time. Yet they periodically go through convulsions. How do you explain that? Countries that are far from the frontier in terms of these attributes did not have these problems.
Readers would more appreciate specificity of recommendations and specific insights on how financial systems evolve and grow in developing countries. Surely the Bank by now has a better understanding of financial systems in its member countries and can provide us with more than cliches.
I am also struck by your remark "governments must ensure political stability". Governments don't and cannot ensure political stability. That is the collective task of citizens.

The 347 pages of bank regulations known as Basel II do not contain one single phrase that has anything to do with establishing the purpose of our banks. The regulators, when regulating, should they not start by doing just that?
But then again some could hold that the Basel regulations for banks do contain one explicit purpose - that of not having banks fail… as if not failing would be the ultimate and laudable purpose of a financial system?
Since 1997 I have been arguing publicly since that if banks do not fail in sufficiently large numbers that just evidences that society is not taking enough risks.
But then again some would tell me that the current crisis is clear evidence of too much risk-taking. They’ve got to be joking! Too much risk taking in mortgages, in the US, in AAA rated securities?

@Jag Rao
Finance is risky business and it would be naive to think crises can be eliminated completely. The role of financial sector policies and in particular regulation and supervision is to make crises less frequent and reduce their cost when they occur. But the recent crisis clearly revealed many weaknesses in the policies of industrialized countries too (see my earlier post on the crisis).
The Bank provides plenty of specific financial sector policy advice to its countries through its Financial Sector Assessment Program and its on-going dialogue; and the blog is not the right place for that. But stay tuned on more research insights on the evolution of financial systems.